“According to a recent Nightline
program, none of the Wall Street executives who engineered
the sub-prime debacle have been convicted on criminal
charges. Why do you think that is?”

I think that the most obvious answer is the correct one: the
authorities were not able to find sufficient evidence of
criminal behavior in any of the cases they investigated, and
they investigated many, because there weren’t any to be
found. Imprudent violations of firms’ own internal policies
abounded, but such violations are not criminal.

Lenders
Are Always Profit-Hungry

Underlying your question, and implicit in the Nightline
approach, is an assumption that the sub-prime debacle was
engineered by a profit-hungry group of lenders and
investment bankers who, for some unknown reason, decided to
run amuck. Given that assumption, the failure to convict
anyone must mean either that law enforcement has been
co-opted, or that all the suspected criminals who were
investigated were clever enough to destroy all evidence of
their misdeeds.

But both the assumption and its implications are wrong.
True, lenders and investment bankers are profit-hungry, but
they are always profit-hungry, so this does not
explain anything. Profit-hungry lenders in the 90s made
mortgage loans only to borrowers who met rigorous standards
applicable to their capacity and willingness to repay.
During the period 2000-2006, in contrast,
profit-hungry
lenders made loans to many borrowers who did not meet these
same standards. Profit-hungry lenders did not change their
character between these periods, what changed were the
circumstances under which their decisions were made.

Behavior
In a Housing Bubble Is Different

In the later period, they operated in a housing bubble. A
housing bubble is a market environment in which rising house
prices generate an expectation that price increases will
continue indefinitely. The central feature of a bubble is
self-reinforcement, where price increases lead to actions
that further stimulate price increases. The expectation of
rising prices is the air in the bubble.

Economists don’t completely understand what causes bubbles,
but they appear intermittently throughout history, beginning
with the Dutch tulip mania in the 17th century. A
central feature of all bubbles is that very few of those
participating in them realize that they are in a bubble. A
few mavericks andmisfits not part of the social fabric of the industry
affected may perceive what is going on – in our recent
housing bubble, a few of them madefortunes betting against the market – but the great
majority reinforce each other in the belief that the price
increases will continue. The absurdity of this belief does
not emerge until the bubble bursts, when it becomes
painfully evident.

In a housing bubble, it is extremely difficult to make a bad
mortgage loan. If the borrower’s income is inadequate,
several devices are available to reduce the payment during
the first few years. At the end of that period the loan can
be refinanced with the reduced payment extended, with
confidence that the increase in house value during the
initial period will cover the higher loan balance and
settlement costs on a new loan. If the borrower can’t make
the payments, there will be sufficient equity to allow him
to sell the house and pay off the loan balance. In the worst
case where the lender is forced to foreclose, the equity
generated by rising prices will be sufficient to repay the
balance and cover the foreclosure expenses.

Continuing price increases make underwriting requirements,
which are designed for a static environment, largely
irrelevant. By ignoring them, lenders do good deeds, making
homeowners out of people who never thought they had a crack
at homeownership, and in the process make money for
themselves. In a bubble, everybody wins.

Hindsight
Clarifies a Great Deal

Until they lose. With the perspective provided by hindsight,
it may be difficult to believe that so many intelligent
people, including CEOs of major public companies, believed
(or acted as if they believed) that house prices would rise
forever. But it really wasn’t that implausible. For one
thing, they didn’t have to believe that prices would rise
forever, only that the price inflation would last through
their tenure – when it ended, the resulting problems would
then be someone else’s.Until the crisis, furthermore, there had not been a
nation-wide decline in house prices since the 1930s, only
local ones that were invariably mild and short. Other
countries had experienced sharp price drops, but that was
easily disregarded as irrelevant.

Contagion

The optimism generated by bubbles is also contagious. To
appreciate its force, consider that the bank regulators were
caught up in it almost to the same degree as the industry
players. The regulators did finally realize what was going
on, but only a few months before the bubble burst -- far too
late to do anything constructive about it. And the
regulators were not subject to any of the internal pressures
that blinded the corporations operating within the bubble.

Power
Shifts

A bubble generates a subtle shift in power within
corporations, a shift largely unrelated to the table of
organization that shows who reports to who. Power shifts to
those who direct operations within the bubble, who are
responsible for engineering substantial “profits” for the
firm. Even CEOs with strong personal doubts could not bring
themselves to explain to their boards why they had curtailed
operations that were generating such great results. And both
top management and boards feared incurring the wrath of
major shareholders if they fell behind competitors who were
earning enormous “profits” by operating within the bubble.

Profit
Illusion

In the previous paragraph, I put the word “profit” in quotes
because after the bubble burst we realized that they weren’t
profits at all, they just looked like profits at the time.
One of the major features of the housing bubble was what
might be termed “profit illusion”, and dealing with it is
the key to any successful policy designed to prevent another
bubble in the future.

Public
Policy Reaction to the Financial Crisis

When the housing bubble in the US collapsed, the resulting
financial crisis generated enormous costs – costs that could
have been many times higher if not for timely and massive
interventions by the Federal Government. The consensus of
the post-mortems was that the bubble and subsequent crisis
never should have happened, and that new laws were needed to
prevent it from ever happening again. The result was
Dodd-Frank (DF), a massive piece of legislation directed
almost entirely to that end.

DF is typical of legislation passed in the immediate
aftermath of disasters. With the disaster fresh in mind,
political barriers were easy to overcome, which is the case
for acting promptly. The downside is that the results in
many cases are knee-jerk and not well thought out.

Since the major abuse within the bubble was the violation of
underwriting standards, a major thrust of DF was to create
barriers to that ever happening again. The barrier was to
expose lenders to legal liability if they made loans that
were not “qualified mortgages” as that term was to be
defined by the new Consumer Financial Protection Bureau
(CFPB) established by DF.

Consumers
Are the Big Losers

The CFPB recently
declared that qualified loans cannot have any of a long list
of provisions that are viewed as risky, including negative
amortization, an interest-only period, a balloon payment,
waiver of all documentation requirements, or a term
exceeding 30 years.
Under these rules, which become effective January 1, 2014, a
lender making an unqualified loan that goes into default is
vulnerable to legal action by the borrower. For all
practical purposes, therefore, the market will consist of
qualified mortgages.

This approach will probably prevent another housing bubble,
but it is the most anti-consumer measure that could have
been adopted -- and under the guise of “consumer
protection.” Consumers lose a raft of potentially useful
options that render mortgages unqualified, no matter how
useful they may be in a particular case – not to mention the
innovations of the future that will not materialize.
Innovation would require application to CFPB to accept a new
option as “qualified.” The home mortgage market will be
thoroughly bureaucratized.

A
Better Alternative: Eliminating the Profit Illusion

It didn’t have to be done this way. The many options that
existed during the bubble period could have been preserved
by eliminating the profit illusion associated with the
riskier ones. The profit illusion was an essential part of
the bubble -- without it, the bubble could not have been
maintained or even begun.

You eliminate the profit illusion by eliminating the profit
associated with violating underwriting guidelines. Existing
accounting systems allow lenders to record as income all the
upfront fees collected in originating loans, and all the
interest received from borrowers beginning in month one.
During the bubble, the same accounting system was used for
the best prime loans and the riskiest of sub-prime loans.
When large numbers of the riskier loans went into default,
it became clear that a major part of the “income”collected in prior years was not income at all but
should have been set aside as a reserve for future losses.

Eliminating the
profit illusion requires
that reserves be set aside on each loan based on its risk.
This is “transaction-based reserving”, or TBR. It is common
practice in the insurance industry, including mortgage
insurance, where it works very well.

As applied to home mortgages, a portion of the risk
increment paid by the borrower, say 50%, would constitute a
required
allocation to a contingency reserve. For example, if a prime
mortgage was priced at 4% and zero points, the reserve
allocation for a 6% 2 point mortgage might be 1% plus 1
point. Allocations to contingency reserves don’t become
income for an extended period, and are not taxable until
released.

The designers of DF
operated in an environment hostile to lenders, who were
blamed for the crisis, and solicitous of consumers who were
viewed as victims of it. Yet their “remedy” has been
welcomed by lenders, who appreciate knowing exactly what the
rules are, while it deprives consumers of options that they
would otherwise have, and ought to have. This is what comes
of legislating in the immediate aftermath of a crisis.

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